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Achieving Uncorrelated Returns By Leaving The Herd - SYZ Asset Management

C├ędric Vuignier

16 September 2019

This publication shares the following article from Cédric Vuignier, portfolio manager of the OYSTER Alternative Uncorrelated fund at the Swiss firm, . The author writes about what is needed to achieve the "holy grail" of uncorrelated returns - a common theme in wealth management. Even before the financial crisis of 2008, much mental energy was spent trying to figure out how to achieve genuine diversification in portfolios. That is easier said than done. Since 2008, and the massive monetary easing, aka quantitative easing by central banks, that has, in some eyes, become more difficult.

The editors are pleased to add these views to debate; but they do not necessarily agree with all the opinions. To reply, email tom.burroughes@wealthbriefing.com and jackie.bennion@clearviewpublishing.com

In the world of alternatives, "uncorrelated" is used increasingly to signal an investment strategy’s point of differentiation. The problem is, if everyone is uncorrelated, by definition, no one is. The reality is, despite the great search for differentiated returns, that many strategies frequently turn to similar sources of alpha.

As the hedge fund industry grows, the risk of overcrowded trades increases. Hence, for investors seeking all weather returns and lower portfolio volatility, it becomes even more important to distinguish which strategies are truly uncorrelated.

Going global
We identify truly uncorrelated sources of return by visiting managers not only in the US and Europe but also in Asia, which offers a plethora of undiscovered alpha generators. Geographical diversification is key. For many years, we have seen European and US managers invest in the same deals and in the same way. Because they follow the same risk management approach, they face the same issues when deleveraging. For this reason, we favour relative value managers who dynamically allocate across global asset classes and strategies.

We conduct about 260 manager meetings a year. Face-to-face contact is invaluable insight which complements our quantitative analysis. It allows us to get a real feel for the managers and understand when to dig deeper. As recent news has highlighted, quantitative analysis can sometimes miss crucial information, such as potential liquidity issues.

By travelling around the world, we are also able to get a sense for different market sentiments and spot future trends and new strategies. Recently, we have followed the explosion of big data and machine learning and how they contribute to the development of quant strategies in particular.

Staying on top of trends
We invest considerable time in understanding niche strategies, such as volatility arbitrage or quant strategies, as these offer a further source of diversification away from traditional hedge funds. Volatility is a niche area and challenging to grasp due to its embedded complexity, yet the space has become a recurring topic of discussion since February 2018, when the VIX volatility index experienced its largest one-day move to date.

We are tactical in our allocation to volatility and have various tools at our disposal to capitalise in this space, across four styles – tail risk, long volatility bias, relative value, and short volatility. Given the emphasis we place on diversification, we frequently implement relative value strategies, which target an uncorrelated, diversifying, all-weather return stream.

Finally, we use an in-house quantitative system to carry out a diversification check on the portfolio. The process allows us to gauge factor attribution within the portfolio. We are then able to adjust the portfolio in consequence, to remove or change the weighting of an underlying fund to optimise diversification.

Adapting to market movement
As we come to the end of the cycle, and with geopolitical tensions rising globally, investors are increasingly looking for uncorrelated strategies. Dovish central banks will likely extend the uptrend in equity and credit cycles, benefiting directional managers. However, we believe the higher volatility of the last 12 months will persist, owing to ongoing sources of tension worldwide, slower expected growth and lower liquidity. As a result, we are maintaining a bias to relative and macro strategies, which benefit from market dislocation.

As volatility re-emerges, we also see an opportunity in volatility dispersion strategies. Dispersion seeks to take advantage of relative value differences in implied volatilities by shorting an index and going long on a basket of the index’s constituent stocks. Due to demand for hedging, index options tend to trade at a higher implied-to-delivered volatility premium than single stock options. As a result, implied correlation also typically trades at a premium to delivered correlation.

Dispersion usually works well during times of market segmentation, temporary shifts in correlation between assets, and idiosyncratic news on individual stocks. Generally, the most supportive environments for dispersion are when volatility increases and remains elevated, such as in Q4 2018.

As market directionality starts to splinter, the opportunity set for uncorrelated returns will grow. In the meantime, it is possible to achieve truly uncorrelated returns through geographic and strategy diversification, by investing the time and effort into researching a broad range of managers and strategies across markets.